1. The balance of payments and its accounts
- Meaning: a systematic record of all economic transactions between residents of a country and the rest of the world during a year.
- Current account: trade in goods (visible), services, primary income (interest, dividends, wages) and transfers (gifts, remittances). It does not change foreign assets or liabilities.
- Capital account: direct and portfolio investment, loans (borrowing and repayment), banking capital such as deposits of non-residents. It changes foreign assets or liabilities.
- Balance of trade = merchandise exports − merchandise imports (visible items only).
| Basis | Current account | Capital account |
|---|---|---|
| Records | Goods, services, income, transfers | Investment, loans, banking capital |
| Assets and liabilities | No change | Changes them |
| Example | Tea exports | Purchase of shares by foreigners |
| Imagined transaction | Account | Receipt or payment |
|---|---|---|
| A Surat firm exports diamonds | Current: goods | Receipt |
| Indian families holiday in Thailand | Current: services | Payment |
| A nurse abroad sends money home | Current: transfers | Receipt |
| Interest paid on a foreign loan | Current: income | Payment |
| A foreign firm builds a factory in India | Capital: direct investment | Receipt |
| An Indian firm repays a foreign loan | Capital: loans | Payment |
Key terms
- Visible items
Exports and imports of goods.
- Invisible items
Services, income and transfers.
- Capital account
The part of the balance of payments that records changes in foreign assets and liabilities.
2. Working out the balances
- Current account balance = balance of trade + net services + net primary income + net transfers.
- Overall balance = current account balance + capital account balance; it is settled by a change in official reserves.
- Imagined Vanadesh (₹ crore): trade -1400, services 1200, income -300, transfers 700; current account 200; capital account 200; overall 400 (reserves rise).
- Imagined Kesarpur shows the opposite case: a trade surplus of 200 but a current account deficit of 300 because it pays heavily for services and income.
| Item | ₹ crore |
|---|---|
| Balance of trade | -1400 |
| Net services | 1,200 |
| Net primary income | -300 |
| Net transfers | 700 |
| Current account balance | 200 |
| Capital account balance | 200 |
| Overall balance | 400 |
Key terms
- Balance of trade
The difference between the values of exports and imports of goods.
- Current account balance
The net result of trade in goods and services, income and transfers.
3. Disequilibrium: causes
- In accounting terms the balance of payments always balances (double entry). Disequilibrium means a gap in autonomous items, settled by accommodating items such as the use of reserves.
- Causes of a deficit: imports for development; a fall in exports (high costs, weak foreign demand, poor quality); inflation at home; natural calamities; debt service; population growth; political instability that drives capital out.
| Cause of a deficit | How it works |
|---|---|
| Development imports | Machines and equipment for growth raise payments |
| Fall in exports | Weak demand abroad or high costs at home |
| Inflation at home | Exports dearer, imports cheaper |
| Natural calamities | Farm exports fall; food may be imported |
| Debt service | Interest and repayments on foreign loans |
| Population growth | More imports of food and essentials |
| Autonomous items | Accommodating items |
|---|---|
| Undertaken for their own sake (profit, need) | Undertaken to settle the gap |
| Trade, travel, remittances, investment | Use of official reserves, loans from abroad to cover the gap |
| Decide surplus or deficit | Make the account balance |
Key terms
- Autonomous transactions
Transactions made for their own sake, such as trade and investment.
- Accommodating transactions
Transactions made to settle a gap in autonomous items, such as drawing on reserves.
4. Disequilibrium: corrective measures
- Export promotion: tax relief, cheaper credit, trade fairs, better quality.
- Import substitution: produce at home what is now imported.
- Import control: tariffs and quotas on non-essentials.
- Devaluation or depreciation: exports cheaper abroad, imports dearer at home.
- Attracting foreign capital and controlling inflation.
- Quick steps (import control) work fast but can raise costs and invite retaliation; lasting cures (exports, competitiveness) take time.
| Measure | Effect |
|---|---|
| Export promotion | Raises receipts |
| Import substitution | Home output replaces imports |
| Import control (tariffs, quotas) | Cuts payments |
| Devaluation or depreciation | Exports cheaper, imports dearer |
| Attracting foreign capital | Capital inflows finance the gap |
| Controlling inflation | Keeps exports competitive |
Key terms
- Tariff
A tax on imported goods.
- Import substitution
Producing at home goods that were earlier imported.
5. Exchange rate systems
- Exchange rate: the price of one currency in terms of another (here, rupees per US dollar; every rate in SOYL items is imagined).
- Fixed rate: set by the authorities and defended with reserves. Merits: certainty, stable trade and investment, less speculation. Demerits: needs large reserves, no automatic correction, may lead to black markets or sudden devaluations.
- Flexible rate: set by demand and supply. Merits: no need for large reserves, automatic correction of imbalances. Demerits: uncertainty, speculation, swings in import prices.
- Managed floating: market-set rate with central bank action to smooth sharp swings.
| Basis | Fixed rate | Flexible rate |
|---|---|---|
| Set by | Government or central bank | Demand and supply in the market |
| Reserves needed | Large, to defend the rate | Little |
| Change in value | Devaluation or revaluation | Depreciation or appreciation |
| Main merit | Certainty for traders | Automatic correction of imbalances |
| Main demerit | Needs reserves; no automatic correction | Uncertainty and speculation |
Key terms
- Fixed exchange rate
A rate set by the government or central bank and kept there by buying and selling foreign currency.
- Flexible exchange rate
A rate set by the demand for and supply of foreign exchange in the market.
6. Determination of the rate; four terms
- Demand for foreign exchange (imports, travel and study abroad, investment abroad, loan repayment) slopes down; supply (exports, tourists, foreign investment, remittances) slopes up.
- Equilibrium: where demand = supply. Imagined market Qd = 300 − 4e, Qs = 6e − 200: e = 50, Q = 100 million.
- Demand up (e.g. fuel imports): rate rises to 54: the rupee depreciates. Supply up (e.g. foreign investment): rate falls to 44: the rupee appreciates.
- Depreciation / appreciation: market-driven fall / rise in value (flexible). Devaluation / revaluation: official fall / rise (fixed).
- Example: a 3,000 US dollar import costs ₹1,50,000 at 50 and ₹1,62,000 at 54, a rise of 8 per cent in the rupee price of the dollar.
| Term | Direction | Caused by | System |
|---|---|---|---|
| Depreciation | Value falls | Market forces | Flexible |
| Appreciation | Value rises | Market forces | Flexible |
| Devaluation | Value falls | Official decision | Fixed |
| Revaluation | Value rises | Official decision | Fixed |
Key terms
- Equilibrium exchange rate
The rate at which the demand for foreign exchange equals its supply.
- Depreciation
A fall in the value of the home currency caused by market forces.
- Devaluation
An official reduction in the value of the home currency under a fixed rate.
Exam tips
Common mistakes
- Putting services or remittances in the balance of trade (goods only).
- Recording repayment of a loan in the current account (it is a capital item; only the interest is current).
- Saying the rupee "appreciates" when a dollar costs more rupees (it depreciates).
- Mixing up depreciation (market) and devaluation (official).
- Quoting a current exchange rate or Indian balance of payments figure instead of using the data given.
How marks are usually awarded
- 1 mark: one correct choice or a precise term.
- 2 marks: two points, or a definition with an example.
- 3 marks: a calculation in three steps, or three distinct points.
- 5 marks: parts with working, a labelled diagram and reasons; ISC 4- and 8-mark questions are set as 2 + 2 and 4 + 4.
All countries, firms and figures in SOYL practice are imagined; state units and signs in every answer.